V Anantha Nageswaran - When Mr Abe took over as the Prime Minister of Japan, he had to contend with North Korean missiles. Now, he has to contend with Japanese machinery orders—an indication of industrial production. Orders dropped 7.4% year-on-year in September, though the consensus forecast called for a rise of 1.8%. Putting on a brave face, Mr Toshihiko Fukui, the governor of the Bank of Japan (BoJ), had said he expected interest rates to rise “soon.” The short-rate in Japan stands at a paltry 0.25%. Interest rate futures show that the market expects this rate to be around 0.75% by end-2007. That reflects expectations of modest growth and a very slow exit out of deflation in Japan. Mr Fukui obviously does not concur with the market’s assessment. He is concerned about the risks of keeping rates too low rather than the risk of raising them too prematurely. Is he right?

The question is whether the BoJ is about to repeat its policy errors of the past. The Lex column of The Financial Times last Thursday expressed scepticism on the Japanese recovery story, and for good reason. Mr Takenaka, the former financial services minister has questioned the actions of the BoJ in mopping up money supply and liquidity too quickly from the economy. He blames that action for the economic slowdown.

Our belief in the Japanese economic recovery this time is based on the following: (a) It is driven by the private sector; (b) It is coming on the back of a genuine cleanup in the banking sector; (c) It is based on a classical recovery pattern seen in the US in the ’90s with investment spending and corporate profits recovery; and (d) it is based on a firming of land and property prices.

Yet, recent data has created a noise of slowdown so loud it is hard to ignore. Bank lending growth has slowed for the second month in a row. The Economy Watchers’ Survey indicates a softening of the optimism on current conditions. The chart shows that the level of optimism has crested twice at 55 and has been unable to break above that level. It is just above break even now. The October survey is not available yet in English and the details would be as important, if not more, as the headline index reading.

The BOJ would have an easier time in conducting monetary policy if it knew which metric it should be following.

Consumer prices and average wages? They are being held down by globalization-- i.e. the great shift of world manufacturing to China and now India.

Producer prices? Rising due to globalization, as the two Asian giants rapidly increase their demand for the world's commodities and intermediate goods.

Wages at the low end of the scale and unemployment? In the services base wages are rising thanks to the economic recovery and the shrinking of the labor force--but surreptitious immigration (globalization again) may be setting a ceiling on the rise, throwing a wrench in the reallocation of members of the workforce from manufacturing or unemployment to services.

Housing starts? The BOJ's super low interest rates are encouraging vast borrowing by general construction companies, who have kept their businesses going by throwing up gigantic apartment complexes in the former industrial areas of bayside Tokyo.

Investment in Japan? With the government on line to once again reduce spending on public works by 3% in the coming fiscal year and the current lull in capital investment, how could the BOJ get away with raising the cost of borrowing?

The international value of the yen? The BOJ's super low rates are encouraging the carry trade, the selling of yen on international markets for U.S. dollars, New Zealand bonds--anything that can earn a decent rate of return. The yen stays cheap and the world's markets remain flooded with liquidity, inflating and exacerbating investment bubbles in the U.S. bonds, in Shanghai real estate, in Australian commodities--just about everything everywhere.